Thursday, September 10, 2015

The bear makes a welcome return

The
S&P 500 Index had its worst August since
2001, while the Dow’s 6.6 percent drop was its biggest since declining 15
percent in August 1998. Most investors
consider the September-October period to be the witching months for equities,
but the past month was a painful reminder to many of them just how bad August
can sometimes be.

Along those lines, Bloomberg has observed that whileAugust ranks in the
middle among months based on share performance, it has produced some of the
worst returns of the year since 2009.
During the week ended August 12, 2011, the S&P 500 alternated
between gains and losses of at least 4 percent for four days, something never
seen in 88 years of data compiled by Bloomberg.
In 2013, the S&P 500 fell 3.1 percent in August, one of only two
months of negative returns in a year when the index surged 30 percent.

Since
the late August sell-off, there has been a constructive development underway in
terms of investor psychology. The
market’s sentiment profile has shown vast improvement since the last month
before the sell-off. The following
magazine headline from a recent issue of Bloomberg
Businessweek is a classic example of the magazine cover indicator at work.

That’s
right, a cover full of bears! From a
contrarian standpoint it doesn’t get any more emphatic than this.

Below
is another manifestation of the bear on a recent news magazine cover. The headline questions whether a bear market
is imminent, which has definite contrarian implications.

The
bear analogy can also be seen in the Sept. 7 issue of The New Yorker. Even The Economist got in on the act with a
Sept. 4 reference to China’s market decline (the alleged cause of Wall Street’s
plunge) on its front cover.

These
are the type of magazine cover that appears at, or very near, important interim
lows. While the magazine cover indicator
can’t always be used to time the exact location of the bottom, it does provide
an important “heads up” that the bottoming process has most likely begun with a
confirmed interim bottom to follow in the weeks immediately ahead.

The bigger question
confronting investors is whether the August correction was simply a one-off
event or the prelude to something much bigger? This is a question
that will undoubtedly be given much attention by analysts in the weeks
ahead. To proclaim the termination of the 2009-2015 bull market right now
would be premature in my opinion. I believe an established long-term
uptrend should be given every last benefit of the doubt to prove itself before
proclaiming its death. If the bull market is to persist beyond 2015,
however, it’s imperative that the internal condition of the stock market
relative to the new 52-week highs and lows substantially improve. Otherwise
the situation we witnessed in August will only repeat at a later date.

Market episodes like the
late August sell-off rarely occur out of a clear blue sky. The
market usually provides a preliminary warning to give wary participants a
“heads up” that something bigger could be on the horizon. For
instance, in the lead-up to the 2008 credit crash there were several early
warning signals in the stock market beginning with the February 2007 correction
and again in August that year. The preliminary warning to the recent
correction was the NYSE electronic outage in early July. NYSE
trading screeched to a halt for nearly four hours on July 8, which officials
blamed on a “technical glitch.” The event spooked investors, which was a
further sign that market psychology was vulnerable to another surprise event.

Investor fear seems to
have reached a crescendo since early September, however, and any further
erosion in fear from this point could serve as a catalyst to short covering
rallies, near term. The latest Bullish Consensus indicator (below)
has reached its lowest reading of bullish sentiment since 2013. This
is also a sign of a healthier market from a contrarian perspective.

By
far the most important ingredient needed for a major bottom and re-entry signal
is a significant contraction of the number of stocks making new 52-week lows on
the NYSE. The number one problem that
has plagued the stock market since the beginning of summer has been the
persistence of internal weakness. It’s
also what made the market vulnerable to the correction that occurred last
month. This can be seen in the fact that
on most days the number of stocks making new 52-week lows has exceeded 40,
which is the historical dividing line between a healthy and an unhealthy market
environment.

Only
once this month to date has there been fewer than 40 new lows (Sept. 3). Each day this week (Sept. 7-11) has witnessed
an expansion in the new 52-week lows, culminating with 131 new lows as of this
writing on Sept. 10. This is
unacceptably high and tells us that there is still some internal weakness
within the broad market. Moreover, this
weakness must be resolved before the market launches its next sustained rally.